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United States Monetary Policy December 2016

United States: Fed raises interest rates for second time since global financial crisis

December 14, 2016

At its final monetary policy meeting of the year, held on 13–14 December, the Federal Reserve’s Open Market Committee (FOMC) announced its decision to raise the target of the Federal Funds rate from a range of between 0.25% and 0.50% to between 0.50% and 0.75%. The decision was widely expected and came a year after the first U.S. interest rate hike since the global financial crisis. That said, the Fed’s forecast of a faster pace of tightening in 2017 surprised the markets, which had priced in a gentler upward path for the Fed Funds rate.

The FOMC made only modest changes to its statement relative to previous ones. The U.S. monetary authority indicated that the increase was warranted due to “realized and expected labor market conditions and inflation.” Also, the Committee signaled that the stance of monetary policy remains “accommodative”, which would help achieve “some further strengthening” in the labor market. The “some” qualifier was added in this statement, which suggests that monetary authorities believe the economy is near full employment. Elsewhere the statement noted that the economy has been expanding at moderate pace and signaled that inflation expectations had increased “considerably”.

In the summary of economic projections, the U.S. Central Bank made relatively few changes to its economic forecasts. However, it upgraded its projection for the Funds rate. The median projection for the monetary policy rate showed three rate increases in 2017—up from two in its September forecasts—and no changes in the number of hikes in 2018 and 2019. Longer-term projections for the interest rate were also raised, with a median projection increasing to 3.00% from 2.875%, previously. That said, Fed Chair Janet Yellen played down the scale of the forecast increase for 2017, calling the outlook a “modest adjustment”.

The decision to increase interest rates in December came before Donald Trump takes office in January and as the new administration contemplates tax cuts that could boost economic activity and inflation. In a press conference after the rate announcement, Janet Yellen was repeatedly pushed to discuss the impact of expected tax cuts and spending plans on the Fed’s policy stance. She mentioned that monetary policy makers “are operating under a cloud of uncertainty at the moment” and added that, “changes in fiscal policy or other economic policies could potentially affect the economic outlook.” She finalized by saying, “it is far too early to know how these policies will unfold. Moreover, changes in fiscal policy are only one of the many factors that can influence the outlook in the appropriate course of monetary policy.”

Commenting on the Fed’s decision and future path of interest rates, Johnny Bo Jakobsen, Chief U.S. Economist at Nordea said:

“The bottom-line message remains that Fed policy will most likely begin the next year by maintaining a gradual approach to rate hikes and will respond to potential fiscal stimulus only once it's actually in place and the data warrant additional action. Until we get more details about Trumponomics, the US economic and monetary policy outlook is subject to increased uncertainty. Assuming an overall benign policy mix with fiscal easing and only minor restrictions of trade and immigration, we continue to expect two Fed hikes in 2017, despite the Fed’s slightly more hawkish dot plot today.”

Following the Fed’s rate decision and outlook, the U.S. dollar climbed to the highest level since 2003 against the euro and gold prices plummeted to a 10-month low, as prospects of a steeper path for U.S. interest rates in 2017 resonated through most markets. Stocks led gains in major U.S. equity benchmarks and U.S. 10-year yields reached the highest level in over two years. As the greenback extended its gains, most emerging market currencies fell. The Fed’s move also represents a marked shift away from monetary policy in other major central banks.

The U.S. Federal Reserve’s interest rate median projection forecast for 2017 averages 1.4% (previous estimate: 1.1%). According to FocusEconomics’ survey, the target range for the Fed’s Funds Rate will end at between 1.00% and 1.25%, with an average Consensus of 1.22%. For 2018, the Fed projects, on average, that the federal funds rate will end 2018 at 2.1% (previous estimate: 1.9%). The Consensus view among analysts of the Fed’s key rate in 2018 are more varied and see, on average, that the Fed funds rate will end 2018 at 1.78%.

Author:Ricardo Aceves, Senior Economist

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